This article was originally published by Seeking Alpha on October 12th, 2017
Proactive approach to risk will protect squeezed returns in emerging markets
Back in February the Institute of International Finance forecast another disappointing year for capital flows into developing economies. They cited the continuing retreat of foreign investors from China, ambiguity of the direction of the Trump administration and general uncertainty over global economic outlook. Alongside headline data such as Chinese investment into Africa falling 84% in 2016, it was to be another muted year for opaque markets.
Fast forward 8 months and the IIF revised its prediction, announcing this year will deliver the first net surplus in four years with more than $1tn inward investment. This is as global inflation stays subdued and investor risk appetite grows and the MSCI’s EM index recently posted a 6-year high and a YTD net return of over 27%. Even Tajikistan’s inaugural Eurobond offering surpassed expectations, knocking 90 basis points off initial price guidance, and the latest issue of The Economist devoted significant column inches to discussing the building resilience in middle income markets.
At the micro level, inflows are increasing across the capital structure. Direct, private equity and particularly credit deals are abundant, as are public securities trading long and short. Trade financing initiatives are also on the rise and such news that Deutsche Bank is building out it’s EM trade finance team whilst IBM develops a new global payments system adds validity to the upturn.
These numerous investment strategies sit alongside considerable, broad-ranging market differences and each require a highly tailored approach to risk management. As funds and managers broaden their outlook and new entrants consider a more proactive approach to investing in both developed and developing markets, a front heavy, generic box ticking attitude to mitigating risk is no longer, and never was, fit for purpose.
First and foremost, due diligence carried out on individuals and corporations cannot be comprehensive if offline methods of information acquisition are not utilised when operating in significantly offline markets. In many countries in the developing world detailed public records exist, but only in physical form. ‘Enhanced’ due diligence has uncovered reputation concerns ranging from terrorism funding to drug running, none of which would have been found relying on a database search or desktop research of social media outlets. Furthermore, verification of isolated assets utilising local specialists often uncovers a range of irregularities.
In country expertise is vital to navigating new markets, whether it is seeking out local lawyers, bankers or partners, or in order to keep the right side of regulators who may have a dispassionate view of overseas investors. For example, foreign activists in Asia have been met with hostility when executing strategies in Hong Kong and China, particularly in fraud short scenarios as capital flows increase between the two. Situational awareness at high level and ground level is mandatory and the approach must be as bespoke as the investment strategy one seeks to implement.
For all the enterprise risk modelling that is undertaken pre-investment, it does not, and should not, negate the requirement for monitoring and oversight during the lifetime of the project and can save as well as make money in the long run. Regularly, investment teams are well stretched and once signed off on one they are onto the next, often in a very different jurisdiction. This leaves little bandwidth to keep an eye on their ongoing operations. Supply chain integrity and the risk of theft and corruption, particularly when financing trade across the globe, typically gets priced in rather than proactively mitigating against in real time; the mindset of writing down is pervasive. Losing a proportion of, say, an oil consignment should not be common, but the monitoring of the shipment is deemed either uneconomical or impractical. It would only take an individual sitting in the delivery port overnight to uncover the tanker had been fitted with a false floor, skimming off each time the tanker is filled (this real-life scenario was only uncovered after many months of theft). Proactive and discrete asset protection will always be cheaper than the write-down or the subsequent investigation after the fact.
A new and proactive approach to risk management in emerging markets is necessary and should incorporate the latest technological solutions as well as offline, on the ground intelligence. Reducing relative risk in this way is economical and delivers safer returns and investing resilience in the long run. Whilst current margins can support a hands-off mentality, the increase in capital supply and confidence in the coming years will require a more granular approach to management to stay ahead of both competitors and the market.